Principles of Financial Engineering, 2nd Edition

CHAPTER 7

Dynamic Replication Methods and Synthetics

1. Introduction

The previous chapters have dealt with static replication of cash flows. The synthetic constructions we discussed were static in the sense that the replicating portfolio did not need any adjustments until the target instrument matured or expired. As time passed, the fair value of the synthetic and the value of the target instrument moved in an identical fashion.

However, static replication is not always possible in financial engineering, and replicating portfolios may need constant adjustment (rebalancing) to maintain their equivalence with the targeted instrument. This is the case for many different reasons. First of all, the implementation of static replication methods depends ...